Thursday, October 16, 2008

Crisis Reverberates in Credit, Stock Markets - WSJ

Governmentes actions triggered unintended actions:
1.ABCP led to the slump in unsecured CP market
2.Capital injection into banks led investors to favor bond bonds instead of agency bonds
3.Increased FDIC guarantee limited led investor to park their cash in bank accounts, not money market funds.
Government efforts to heal the credit markets are having unintended consequences that are roiling different sectors of the market and adding to anxiety among investors, who already are worried about the impact of a possible recession on U.S. companies.
Barely two days after the Treasury announced plans to buy stakes in U.S. banks and the Federal Deposit Insurance Corp. said it would provide guarantees on bank debt for three years, investors are making unexpected shifts.
Wednesday, bonds issued by mortgage providers Fannie Mae and Freddie Mac sold off sharply, even though these companies have government backing behind their debt. Traders said hedge funds were forced to sell as they deleverage, and investors were selling some Fannie and Freddie bonds -- known as agency debt -- and shifting money into bonds issued by large U.S. banks. These bank bonds boast higher yields and also would benefit from implied government guarantees, making them appear relatively safe in the eyes of risk-averse investors, for now.
The difference between yields on two-year Fannie Mae bonds and Treasury notes rose 0.25 percentage point Wednesday to 1.5 percentage points. That gap was less than a single percentage point when the government said in early September that it would place Fannie and Freddie under conservatorship.
The bonds issued by Citigroup Inc., Goldman Sachs Group Inc. and Bank of America Corp. gained over the last two days.
Investors have begun "to realize how potent the new FDIC-backed bank paper could be," said Jim Vogel, an analyst at FTN Financial, who recently noted that there is some debate over how explicit the government's guarantee of Fannie Mae- and Freddie Mac-backed debt is.
The agency debt's selloff is the latest unexpected market response to Federal Reserve and Treasury attempts over the past few weeks to plug the financial system's holes. The bailout plans may force the U.S. to issue new government debt that could drive up interest rates on mortgages, undermining efforts to rescue the housing market, the very problem that started it all.
Also, last month, the Fed moved to backstop short-term debt called asset-backed commercial paper, which led investors to pull away from the other half of the short-term debt market because it had no government guarantee. This debt was issued largely by corporations and European banks.
Not long after, the government's move to provide more insurance for bank deposits caused some money managers to change the way they allocate their funds.
"Things are moving so fast, it's hard for anyone to know what is going on," said Jim Goulding, manager at Chicago trading firm GH Traders LLC.
While Treasurys remain popular now, because of a flight-to-quality trend that feeds off their safety, another unintended impact may be in the wings. The bailout plans will result in massive new issuance of U.S. Treasurys, sold to pay for it all. This likely would dilute the Treasury bond market, drive down prices, push up yields and cause mortgage rates to rise.
A miniature version of this happened this week. The average 30-year mortgage rate, which is based off of the 10-year Treasury rate, rose to 6.75% Wednesday from 6.05% Oct. 6, as the 10-year Treasury yield rose, according to HSH Associates.
"You have unintended consequences that spark government actions, that create other unintended consequences," said David Kotok, chairman at money managers Cumberland Advisors.
The Fed's efforts to unlock the short-term markets also have had meddlesome effects. The FDIC may have stopped the flood of withdrawals from banks when it agreed to insure deposits in accounts up to $250,000, up from $100,000, but this has led many money-market fund managers to stay out of the short-term debt markets, particularly for commercial paper. They worry that cash-strapped Americans and corporate treasurers will favor simple bank accounts over their funds even though they pay slightly higher returns.
Money-market fund managers are traditionally large participants in the commercial-paper market, where companies and banks finance near-term obligations.
The managers remain uncomfortable investing in debt that matures in more than a day. They still are holding on to large cash positions in case they are hit with redemption requests from investors.
The government's plan isn't a "panacea for money markets," said Alex Roever, fixed-income strategist at J.P. Morgan Chase & Co.
In mid-September, when the Fed agreed to lend to U.S. banks with asset-backed commercial paper as collateral, the move was intended to unlock the market and help mutual funds sell the debt to banks in order to meet investor redemptions.
In the weeks following the Fed move, some commercial-paper brokers lamented that the Fed's implied backstop for the asset-backed commercial-paper market caused investors to favor the higher yielding asset-backed debt over unsecured commercial paper issued by many corporations and European banks.
The imbalance squeezed European banks already having trouble funding themselves, and the Fed ultimately had to step in again to offer short-term loans directly to companies and banks